1 A Presentation by AlphAmerica Asset Management and PairsTrading.com on Pairs Trading: Leveraging Expanding Technologies Prepared by: Douglas S. Ehrman For more information, please contact us at or

2 Pairs Trading is the synthesis of 3 basic elements: The Elements of Pairs Trading Overview The Market Neutral Element The Arbitrage Element The Technical Analysis Element Market neutrality is central to pairs trading because it drives how trades are built and analyzed, it defines relative risk metrics & it serves as the basis for the overall trading strategy. Arbitrage is central to pairs trading because it provides the framework for the success or failure of a trade, and, therefore is the basis of absolute risk management. Technical analysis is central to pairs trading because it provides many of the tools by which a trader may make decisions about both the quality and the timing of any potential trade.

3 Many types of neutrality must be considered: The Market Neutral Element Sector or Industry Neutrality Market Capitalization Neutrality Beta Neutrality A pairs trade that crosses sector or industry lines may be statistically attractive, but each leg of the trade is acted on by different market forces that may affect the ultimate success of the trade. Pairing stocks with significantly different market caps may leave a trade vulnerable to regular market rotations. Pairing stocks with significantly different betas builds a market direction bet into a trade where it may not be wanted. While total beta neutrality is very difficult, a pairs trader must always be aware of the betas of the two stocks he or she is pairing.

4 Share Neutrality vs. Dollar Neutrality: The Market Neutral Element Share Neutrality The classic “spread” trade Not really market-neutral Creates situations of proper analysis while still losing money Pure “pairs” trade Assures proper analysis leads to profits Example Stock A - $10 Stock B - $5 Share Neutral Spread Long 1000 Shares A = $10,000 Short 1000 Shares B = $5000 Dollar Neutral Pair Long 1000 Shares A = $10,000 Short 2000 Shares B = $10,000 Dollar Neutrality Market Falls 20%, Stock A Outperforms Stock A - $8.50 Stock B - $4 Long 1000 Shares A = $8,500 Short 1000 Shares B = $4000 Net = Loss of $500 Long 1000 Shares A = $8,500 Short 2000 Shares B = $8,000 Net = Profit of $500

5 The Arbitrage Element The Importance of Correlation Application If ABC and XYZ are highly correlated, the ratio of their two prices will be very stable when considered over a long period of time. Over time, the price ratio stays very close to its historical average, in this case, about 1.5.

6 Application Despite the high level of correlation, there will be a degree of fluctuation when the price ratio is considered across a shorter period of time. There is oscillation around the average historical price ratio. By entering a trade at an extreme, there is a high probability that the direction of the ratio will reverse and the pattern will repeat. This process is called mean reversion. The Arbitrage Element The Importance of Correlation

7 Application Market neutrality eliminates most of the affects of movements in the general market. Correlation analysis compares the strength of the relationship between the long portfolio and the short portfolio. In a properly constructed portfolio, mean reversion occurs when the long and short portfolio return to their historically average relationship. Mean reversion is an example of relative-value arbitrage which is based on an implied or assumed convergence of a pair’s price ratio back to its historical average. The Arbitrage Element Mean Reversion

8 In most cases, pairs are not as “perfectly” range bound as in the below example. The pair must be considered as a single trading unit. Considering the price ratio creates a single dynamic, dollar-neutral vehicle to which the appropriate indicators are applied. The Technical Analysis Element Non – Perfect Pairs Technical indicators, when applied to the pair, give the trader the tools needed to gage proper entry and exit points; they dictate the timing of pairs trades.

9 The increasing availability and decreasing cost of technology is allowing more and more traders to easily begin trading a pairs strategy. The Investment Process Model or Screening Tool Fundamental / Technical Overlays Additional Statistical Filters PAIRS PORTFOLIO

10 A Pairs Example Cross- Sector Opportunities Exist These relationships tend to last for long periods… International Paper (IP) vs. Kellogg (K)

11 Applying Pairs Techniques to Futures Trading

12 Analyzing Similar Commodity Types Futures with similar characteristics Futures with inverse relationships 1. 1.Futures on Stock Indices 2. 2.Energy Complex 3. 3.Agricultural commodities 4. 4.Interest Rate Futures 5. 5.Precious Metals 6. 6.Currencies 1. 1.Gold and the U.S. Dollar 2. 2.Stock Index Futures and Interest Rate Future in Certain Economic Environments 3. 3.Some Currencies

13 Analyzing Similar Commodity Types The Euro Currency Swiss Franc

14 Analyzing Similar Commodity Types Ratio of the Euro divided by the Swiss Franc

15 Analyzing Similar Commodity Types Crude Oil Futures Heating Oil Futures

16 Analyzing Similar Commodity Types Ratio of Crude Oil divided by Heating Oil

17 Natural Correlation December Gold August Gold

18 Natural Correlation Short-term Spread Trading of the Same Commodity Different Months of Expiration December Gold – August Gold 1. 1.Always move in the same direction 2. 2.Move at different rate 3. 3.Constantly create short-term trading opportunities 4. 4.The range is clearly defined 5. 5.Easy to identify entry and exit points 6. 6.Obvious risk management techniques